Transcript Slide 1

Overview of
Pay without
Performance
Presentation by
Jesse Fried
Columbia University
October 15, 2004
Presentation Outline
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Why we wrote the book
The stakes
Part I: Official view and its shortcomings
Part II: Power and pay
Part III: Decoupling pay from performance
Part IV: Going forward
Concluding remarks
Why we wrote the book
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Widespread recognition: many boards
approved executive pay deals that did not
serve shareholders
But we believe still insufficient recognition
about
 Scope and source of problems; and
 Need for fundamental reforms to address
them
Why the book?
To question systematically several
widely-held views about executive
compensation:
 “Rotten apples” view
 “Paying for performance” view
 “Transient lapses” view
 “Independence is enough” view
Why the book?
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“Rotten apples” view:
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Concerns about executive compensation have
been exaggerated: Flawed arrangements have
been limited to small number of firms
Our conclusion:
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It’s the barrel, not a few apples: Problems
have been widespread, persistent, and
systemic.
Why the book?
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“Paying for performance” view:
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Current pay levels might seem high -but are necessary to provide executives
w/ powerful incentives.
Our conclusion:
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Current pay arrangements not designed
to tightly link pay and managers’ own
performance.
Why the book?
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“Transient lapses” view:
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Even if flaws widespread, they resulted from
boards’ mistakes and misperceptions
Boards can be expected to self-correct with time
and better understanding.
Our conclusion:
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It’s bad incentives, not lapses.
Problems stem from defects in underlying
governance structure – governance reforms
needed.
Why the book?
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“Independence is enough” view:
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OK, reforms might have been necessary – but
recent moves to increase director independence
will adequately address past problems.
Our conclusion:
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Strengthening independence is beneficial, but falls
far short of solving problems.
Additional reforms that make boards more
dependent on shareholders are necessary.
Why the book?
To deliver a broader message about
corporate governance in general:
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Executive compensation provides a window for
examining our corporate governance system
The corporate governance system:
 Depends on boards to serve as guardians of
shareholder interests.
 Largely insulates boards from intervention and
removal by shareholders
Why the book?
Our study of executive pay:
 Casts doubt on wisdom of relying on boards to
perform their critical function well under
current arrangements
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Provides basis for our proposals to make
boards more accountable
The Stakes
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Executive pay not merely symbolic. Has
substantial practical importance for
shareholders/policymakers.
Amounts at stake substantial:
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Bebchuk-Grinstein (2004):
 Aggregate top-5 pay during 1993-2002
about $250 billion
 7.5% of aggregate corporate earnings (10%
during 1998-2002)
The stakes (2)
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Excess pay is not only or principal cost. We
show that managers’ influence over
compensation arrangements:
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Dilutes incentives to serve shareholders
Distorts incentives – e.g., ability to unwind
equity gives incentive to improve short term
earnings reports at expense of long-term value
Part I: Official View and its Shortcomings
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The “official view”:
Corporate boards operate at arm’s-length from executives – it’s
a market like any other.
The “official view” - Serves as practical basis for legal rules and public policy.
Used to justify boards’ compensation decisions to
shareholders, policymakers, courts.
 Underlies most economists’ research on executive
compensation
 Used as basis for explaining common compensation
arrangements
 Practices that do not seem to fit considered “anomalies”
or “puzzles”
Problem with the Official View
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The official arm’s length story is neat, tractable, and
reassuring – but it fails to account for realities of
executive compensation.
Executives not only ones whose incentives matter.
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Must look at incentives of directors
Cannot assume they will automatically serve
shareholders in setting executives’ pay.
Have Boards Bargained at Arm’s Length?
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We show many reasons directors favor executives:
 Incentives
 Going along helps chance of re-nomination to board
 CEO’s power to reward directors
 Social factors
 Collegiality and team spirit
 Deference to company’s leader
 Loyalty and friendship
 Cognitive dissonance (directors who are current/former
executives)
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Personal costs of favoring executives are small
Show outside market forces not tight enough to prevent deviations
from arm’s length bargaining
 Such deviations can occur without subjecting managers and
directors to large costs
Part II: Power and Pay
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The same factors undermining arm’s-length
bargaining indicate managers have power over
boards
Executives use power to influence own pay
Managers extract “rents:” the difference between
what they get and what that they would get under
true arm’s length bargaining
Power and Pay: “Camouflage” and its Costs
Rents not unlimited. Limits on how far directors will go, how far
managers want them to go
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Importance of outside perceptions and appearance: “outrage”
 More outrageous an arrangement is perceived, greater
market and social costs to executives and directors
“Camouflage:” Outrage gives compensation designers
incentive to obscure and legitimize both level and performanceinsensitivity of executive compensation
Costs of camouflage: Attempts to camouflage can lead to
adoption of inefficient compensation structures – structures
that are less efficient but good at obscuring, legitimizing
amount of pay and insensitivity to performance
Evidence of Managerial Influence (1)
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We predict managerial power vis-à-vis board/shareholders
to be correlated with pay arrangements that are more
favorable to insiders
Indeed, there is empirical evidence that pay is
greater/less sensitive to performance in firms with
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More antitakeover provisions
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Weaker shareholder rights
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CEO who is also chair of board
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Directors appointed under current CEO
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Compensation committee has little company stock
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More interlocking directors
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Without large outside block-holders
Evidence of Managerial Influence (2)
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We present evidence compensation arrangements often
designed to camouflage rents and minimize outrage.
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firms have systematically made less transparent both
total amount of compensation and extent pay
decoupled from managers’ own performance.
We show widespread use of various types of
compensation – such as postretirement perks and
consulting arrangements, deferred compensation, and
pension plans – unlikely to reflect efficiency
considerations.
Evidence of Managerial Influence (3)
Golden Goodbyes
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We document how boards provide managers with more
than they were contractually entitled to -- grant “golden
goodbyes” to executives when they retire, resign, or their
firm is acquired, even when the performance of the
manager is sub-par
Given managers’ influence over board, such golden
goodbyes might be necessary to get a majority of the
board to agree to fire CEO or sell the company
But their presence indicates the influence managers have
over the board.
Part III: Decoupling Pay from Performance
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Rise in executive compensation has been justified
as necessary to strengthen incentives
Financial economists have applauded:
Shareholders should care more about incentives
than about the amount paid executives.
“It’s not how much you pay, but how” (Jensen &
Murphy)
Institutional investors have accepted higher pay
as price of improving managers’ incentives
Decoupling Pay and performance (2)
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Managers’ influence has enabled them to get arrangements
that tie compensation too loosely to own performance
The result:
 Much of additional value provided to execs has not been
tied to own performance: shareholders have not received as
much bang for the buck as possible
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Firms could have generated the same increase in incentives
at much lower cost, or used the same amount to generate
stronger incentives
Indeed, seeming legitimacy of equity-based compensation
has enabled execs to obtain amounts that would have
been impossible to get as cash compensation
Decoupling Non-Equity Pay
There is only a weak link between managers’ own
performance and
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Bonus, salary, and other forms of cash
compensation
The large amounts of “stealth compensation”
given through retirement plans
Decoupling of Equity-Based Compensation
But what about equity-based compensation?
 Devil is in the details: Equity-based pay delivers much less
pay for performance than believed
 Windfalls: Rewards for general market and industry-wide
movements. Most of value in conventional options and
restricted stock rewards managers for “luck”
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Re-pricing, “backdoor repricing”, reload options – all
further weaken link b/w pay and performance
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Broad freedom to unload vested options/restricted stock
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Rewards for short-term price increases that may not
last while
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Producing perverse incentives
Part IV: Going Forward
Improving executive compensation
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Transparency: not enough for information to be
in public domain – must be easy to access,
understand.
 For example, companies should be required to
report annual increase in present value of
retirement benefits
Institutional investors should press for tightened
link between pay and performance in ways we
identify
Going Forward: Limits of Independence
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Recent reforms, including new stock exchange listing
requirements, emphasize strengthening director
independence from executives. These reforms will reduce
but not eliminate directors’ pro-executive tilt:
Going along still generally remain safest strategy for being
re-nominated
Executives’ ability to reward cooperative directors is reduced
but not eliminated
Social and psychological factors – collegiality, deference to
leader, loyalty, cognitive dissonance – all remain
As long as directors do not have meaningful incentives to
enhance shareholder value, even a significantly reduced tilt
in favor of executives can have a major impact
Even if complete independence from executives could be
achieved, still concern: directors might pursue own
objectives at expense of shareholders
Going Forward: Beyond Independence
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For each company, vast number of individuals could be
considered “independent directors”
Two key questions
 (1) Who is selected from this vast pool?
 (2) What will their incentives be once appointed?
Strengthened independence eliminates some people from
pool, reduces bad incentives for those appointed. But
does not fully answer (1) and (2)
To improve director selection and incentives, we must not
only make directors more independent of executives, but
also make them more dependent on shareholders
Going Forward: Making Directors More
Accountable
Current insulation of boards from shareholders not
inevitable product of dispersed ownership; rather, largely
results from legal arrangements in place. We should:
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Make it easier for shareholders to replace directors
 Election reform (including shareholder access to the
ballot) is needed
 Shareholder power to replace the board is currently a
myth – it should be turned into reality
Give shareholders power to initiate and adopt charter
amendments.
 Abolish management’s control over changes in
corporate governance arrangements.
Making Directors More Accountable
By making boards accountable to shareholders and
attentive to their interests, such reforms would:
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Make reality more closely resemble official story of
arm’s length negotiations
Improve executive compensation arrangements
Improve corporate governance more generally
Alternative Critiques
Our critique of executive compensation differs from two other types:
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The ethical/fairness critique.
 The critique: People should not be paid as much
 Our view: instrumental and shareholder-oriented. Would accept
higher compensation if were beneficial for performance.
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Incentives don’t matter critique:
 That view: Monetary incentives unnecessary to motivate executives
 Like defenders of current pay arrangements, we believe that
incentives do matter
 This is why we worry that directors lack sufficient incentives to
guard shareholder interests.
 We believe: executive compensation can provide useful incentives
– but managers’ influence over incentive machinery has resulted in
compensation being not only instrument for reducing agency costs
but also part of the agency problem itself.
Recognition and Reality
This is area where perceptions matter a great deal. The very recognition
of problems may help alleviate them:
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Executive compensation practices: Widespread recognition of how
managerial influence distorts pay arrangements serves as a useful
check
 Makes it more difficult to camouflage rents and pay-performance
insensitivity.
Corporate reforms: Given management’s clout as an interest group,
reforms possible only if shareholders, public officials have fuller
understanding of pervasiveness and cost of current flaws in governance
Helping to bring about such an understanding is a main aim of our
book.
Conclusion
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The problems of executive pay are not behind us
– no reason for complacency
The promise of executive compensation yet to
be fulfilled